a study of the market's reaction to superior sustainability reporting as demonstrated by the financial performance of publicly traded companies

Lawrence Technological University College of Management A Study of the Market’s Reaction to Superior Sustainability Reporting as Demonstrated by the Financial Performance of Publicly T

Lawrence Technological University

College of Management

A Study of the Market’s Reaction to Superior Sustainability Reporting as Demonstrated by the Financial Performance of

Publicly Traded Companies

Presented in partial fulfillment of the requirements

for the degree of

Doctor of Business Administration

Derek A D’Angela

3315101

2008

Copyright 2008 by D'Angela, Derek A.All rights reserved

Recent ethical lapses by business organizations and their management suggest that

traditional governance requirements have had less than the desired effect Legislated disclosure alone is insufficient as it provides reactionary guidance that fails to address performance issues since rules can be circumvented and financial data can be tweaked to reflect its most favorable presentation The research evaluated sustainability reporting as

an additional resource for reporting on ethical performance and addressed the question of whether companies that demonstrate ethical leadership through best in class sustainability reporting performed better than their peers in terms of value creation

The study evaluated a group of top companies recognized in the SustainAbility Global Reporters Listing for 2006 against the market performance of securities traded on the S&P 500 Index during the period of January 1, 2002 to December 31, 2006 The selected datasets were compared relative to the dependent variables of risk and return to identify any potential differences in the datasets The research does not imply causality, as

sustainability reporting itself does not create value This is also why the study did not conclude that companies that fail to report on sustainability issues were bad performers; rather organizations could potentially increase their value by doing more to communicate their performance Strong financial performance may encourage enhanced disclosure; in that case sustainability reporting provides a manner by which organizations can

demonstrate sound financial decision-making Sustainability reporting may be viewed as

a best in class business process that ethical and operationally efficient organizations use

to communicate their activities

Lawrence Technological University

College of Management

A Study of the Market’s Reaction to Superior Sustainability Reporting as Demonstrated by the Financial Performance of

Publicly Traded Companies

Presented in partial fulfillment of the requirements

for the degree of

Doctor of Business Administration

Derek A D’Angela

COPYRIGHT

Copyright © 2008 by DEREK A D’ANGELA All rights reserved

ACKNOWLEDGMENTS

I would like to express my thanks and appreciation to the many individuals who have supported me in the completion of my doctoral work I would especially like to thank my chair, Dr Patricia Castelli, for her generous time and commitment Her

guidance and support were of significant benefit and enabled me to maintain the focus necessary to complete the program culminating with the execution of this study

I am also very grateful for having an exceptional doctoral committee and wish to thank Dr Frank Castronova, Dr Vernon Hoffner and Dr Jacqueline Stavros for their continual support and contribution to shaping this research I truly appreciate the time they took from their already full schedules to provide their particular insight to enhance the character of the work

I wish to express my gratitude to the many other individuals who directly

participated or indirectly supported my work during this program including Mike Rinkus,

Dr Tom Marx, the members of DBA Cohort 1 and the faculty and staff of Lawrence Technological University I would also like to offer a sincere thank you to the

individuals who laid the foundation for my interest and success in this program, including the professors and staff of Eastern Michigan University, Hillsdale College and from my earliest days at University Liggett School

Finally, I want to acknowledge the revolutionary thinkers from whom I have inherited the ethical and free market principals that inspire my research

TABLE OF CONTENTS

CHAPTER 1 INTRODUCTION 1

1.1 Background 1

1.2 Key Variables 4

1.3 Market Assimilation and Reporting 7

1.4 Capital Asset Pricing Model 8

1.5 Purpose of Study 10

1.6 Research Question and Hypotheses 11

1.7 Definition of Terms 14

1.8 Limitations of the Study 16

1.9 Significance of the Study 17

1.10 Summary of the Issue and Problem Statement 18

CHAPTER 2 LITERATURE REVIEW 20

2.1 Overview of the Literature 20

2.2 Corporate Governance 22

2.2.1 External Governance 23

2.2.2 Internal Governance 26

2.2.3 Professional Standards 29

2.3 Ethical Leadership 31

2.3.1 Shareholder Theory 35

2.3.2 Stakeholder Theory 38

2.4 Corporate Social Responsibility 42

2.5 Sustainability and Sustainability Reporting 45

2.6 Previous Research on the Link between Ethics and Financial Performance 52

2.7 Summary of the Literature Review 56

CHAPTER 3 RESEARCH DESIGN AND PROCEDURES 59

3.1 Overview of the Study 59

3.2 Research Question and Hypotheses 60

3.3 Reliability and Validity 63

3.4 Population and Comparison Groups 66

3.5 Selection Procedures 68

3.6 Data Collection 74

3.7 Data Analysis 75

3.8 Summary of the Research and Design Procedures 78

CHAPTER 4 ANALYSIS OF DATA 80

4.1 Introduction to the Analysis 80

4.2 Research Question and Hypotheses 81

4.3 Organization of Data Analysis 84

4.3.1 Historical Securities Prices 85

4.3.2 Calculation of Beta 85

4.3.3 Calculation of Growth 88

4.3.4 Calculation of Beta and Growth by Sector 90

4.3.5 Calculation of Mean and Application of Statistical Tests 91

4.4 Presentation of Descriptive Characteristics of Datasets 94

4.5 Summary of the Analysis of Data 100

CHAPTER 5 FINDINGS AND CONCLUSIONS 102

5.1 Introduction 102

5.2 Findings 103

5.2.1 Historical Securities Prices 103

5.2.2 Findings Relative to Beta 104

5.2.3 Findings Relative to Growth 105

5.2.4 Calculation of Beta and Growth by Sector 107

5.2.5 Calculation of Mean and Application of Statistical Tests 108

5.3 Conclusions 111

5.4 Future Research 117

5.5 Summary 119

APPENDIX A: Companies Chosen for SustainAbility Global Reporters Listing for 2006 130

APPENDIX B: Multiple Methods Calculation of Key Variables 132

LIST OF TABLES

Table 3.1 Global Reporting Initiative (GRI) Sustainability Reporting Guidelines 60

Table 3.2 Companies Listed by Sector as Selected 61

Table 4.1 Calculated Values for the Key Metric of Beta by Company 87

Table 4.2 Calculated Values for the Key Metric of Growth by Company 89

Table 4.3 Calculated Values for Key Metrics of Beta and Growth by Sector Group 90

Table 4.4 Results of Kolmogorov- Smirnov Test for Normality of Beta and Growth Distributions 92

Table 4.5 Statistical Results of Student’s T-test Applied to Key Metric of Beta 93

Table 4.6 Statistical Results of Kolmogorov-Smirnov Two Sample Test Applied to Key Metric of Growth 93

Table 4.7 Summary of Calculated Key Metric Results for the SustainAbility Group 94

Table 4.8 Calculated Key Metric Results for the SustainAbility Group 95

Table 4.9 Summary of Calculated Key Metric Results for the S&P 500 Sample 96

Table 4.10 Calculated Key Metric Results for the S&P 500 Sample 97

Table 4.11 Summary of Key Metric Values Calculated Using Company Average 98

Table 4.12 Summary of Key Metric Values Calculated Using Sector Groupings 99

CHAPTER 1 INTRODUCTION

1.1 Background

The concept of ethics has become a very important issue for business leaders, regulators and the investing public Managers face challenges arising from a number of corporate failures and the resulting concern over corporate ethics (Brower, 2006) The issue however is not a new one, rather it is the result of a series of abuses over the past 20 years including Wall Street stock-trading scandals in the 1980s and the savings-and-loan collapse in the 1990s (Martinson and Ziegenfuss, 2000) More recently, corporate

accounting scandals and rapid growth in executive compensation have raised concern among the public regarding the ethical behavior of corporations and their management And new developments surrounding the questionable practice of backdating option grants creates even greater public demand for increased controls and disclosure (Brower, 2006)

The fact that ethical lapses continue to occur suggests that traditional manners of responding to such crises have had less than the desired effect New regulation generally emerges from a developing crisis, is very costly and eventually will begin to experience diminishing returns (Tafara, 2006) Compliance programs, like those required under Sarbanes-Oxley, also have had some effect but fail to address the core issue; if an

organization seeks to reduce the occurrence of unethical conduct it must build an ethical culture (Gebler, 2006) This raises an interesting dilemma, because ethics is a human trait and is demonstrated at the individual level (Drucker, 1981) Therefore, a business in

itself is not ethical; rather it is the individuals within the organization who must exhibit ethical behavior

As the leaders of the organization, management must assume responsibility for establishing the framework for an ethical culture and themselves demonstrating ethical behavior To create an effective internal control system, companies must first have good people and then ensure those people remain good (Buhariwalla, 2006) As such, business leaders must create a business environment and nurture a corporate culture that

encourages ethical performance

Recent scandals involving organizations such as Enron, WorldCom, HealthSouth, Adelphia, Tyco, and even the New York Stock Exchange have represented examples of ethical failures (Shultz, 2003) Rather than focus on these lapses, attention might be given to organizations practicing effective governance and which offer enhanced

transparency to their business operations and performance This perspective is consistent with the framework of Positive Organizational Scholarship, a field of study that focuses

on the positive outcomes achieved by organizations through the application of effective processes and the specific attributes of the enterprise and its members (Cameron, Dutton and Quinn, 2003) Utilizing this approach a thorough understanding of the factors

involved in ethical performance may be achieved, this would help companies and their management to work to implement the practices of ethical performance rather than

working to avoid the previous mistakes made by others

The challenge is not new as the history of the U.S economy and related industry

is marked by a number of issues that have emerged to test corporate leadership Labor management disputes provided early challenges and led to subsequent legislation that has helped shape the current environment (Schlossberg and Fetter, 1986) Prior to 1929 there was little support for federal regulation of the securities markets and most investors gave little thought to the dangers involved; the U.S stock market crash and subsequent

depression quickly changed the public’s attitude toward regulation The outcry following the crash resulted in federal hearings to investigate the matter and led to the Securities Exchange Acts of 1933 and 1934; included was the creation of the SEC with Joseph P Kennedy appointed to serve as its first chairman (SEC, 2006)

The recruitment and management of workers is another theme that in the past has tested the ethical practices of corporations, as a failure by U.S companies to implement fair hiring practices and equal treatment of all employees would lead to further

intervention The development and enforcement of equal employment laws was required

to address the need for improved application of fair standards (Kohl, 1985) As

companies expand across the globe, new issues continue to emerge Consumption of increasingly scarce natural resources can lead to increased competition for those

resources Leading organizations are seeking guidance on reporting activities related to environmental issues to proactively address these concerns (Hutchison, 2000)

The corporate landscape continues to evolve and business leaders must adapt to these changes As companies continue to grow even larger and expand their operations globally, managers will continue to be faced with new opportunities and challenges As

corporate influence grows, internal and external stakeholders are beginning to require social and environmental reporting in addition to financial reporting (Ballou, Heitger and Landes, 2006) This requires sophistication by business leaders to address emerging issues but also a respect for the impact of their enterprise on others

1.2 Key Variables

The topic of ethical leadership was explored as a complement to governance efforts Since ethical leadership is an abstract issue, the paper explored the subject to develop a more robust understanding of ethical considerations demonstrated through the use of sustainability reporting as a means of evaluating financial performance

Specifically, the research evaluated whether companies that demonstrate ethical

leadership through best in class sustainability reporting performed better than their peers

in terms of value creation The study assessed the impact of sustainability reporting as the independent variable to determine whether sustainability reporting had an influence

on firm value The statistical hypotheses tested are outlined in Section 1.6: of this paper titled Research Question

The study focused on two key dependent variables in assessing value:

1) The risk of the firm’s stock based securities as measured by its relative volatility versus the marketplace

2) The return of the firm during a five-year period as measured by its stock price growth during the period being evaluated

These variables were selected due to their inclusion as key variables in the Capital Asset Pricing Model The CAPM model asserts that the market demands a higher return from a firm based upon the relative volatility of the firm’s securities (Kester et al., 1992); the more volatile the security the greater its risk and therefore the higher its required rate

of return or growth Volatility is expressed in terms of a beta value that determines the relative covariance of a specific security to the market; growth is measured as the

appreciation of the security’s value during the same period of time

The two variables were considered concurrently in the study to ensure that any discovered variances were not the result of differences driven by the complementary variable Because higher returns are required when the volatility of the security is

greater, volatility was evaluated to determine if the price differences could be driven by

market expectations for higher returns For this reason, volatility was tested to eliminate that variable being considered as the differentiating factor

A group of organizations recognized as demonstrating effective sustainability reporting was evaluated against the market to test the non-causal relationship between sustainability and risk and reward as the variables of interest Sustainability was

considered as a manifestation of ethical leadership due to the fact that both sustainability and ethical leadership emphasize transparency of operations, balancing long-term value with short-term objectives and the consideration of multiple stakeholder interests This is

consistent with a growing recognition among business leaders that sustainable

development should be viewed as part of the business ethics framework (Payne and Raiborn, 2001) From an environmental standpoint, most competitive and successful multinational companies embrace the need to protect the environment and conserve natural resources (Berry and Rondinelli, 1998) Social considerations also play a

significant role in sustainability

The companies that represented the group evaluated in this study embrace the basic principles of sustainability The sustainable enterprise pursues economic profit while ensuring that they do so in a manner that is not disruptive to people or the

environment (EPA, 2007) In pursuing this “triple bottom line” of people, planet and profit (Elkington, 1998), these organizations demonstrated ethical leadership by looking beyond the self-interest of management to the impact of their operations on others Shareholders, employees, customers, business partners and communities all have an active interest in the operations and success of the firm The challenge for organizations

is to find ways to cooperate with these stakeholder groups while ensuring that they

benefit not only in terms of corporate citizenship but also in competitive advantage (Elkington, 1994) Balancing these long-term interests against the short-term profit targets is a key factor in sustainable development (ERB, 2007) and may serve to reinforce the control structure of the organization and support ethical decision-making Finance plays an especially important role as it relates to sustainability because economic

production has an impact on the environmental performance of the firm and financial development is linked with economic development (Scholtens, 2006)

1.3 Market Assimilation and Reporting

Public confidence in the reliability of financial reporting enables securities

markets to transact effectively (GAO, 2006) The Efficient Market Hypothesis asserts that at all times a security's market price fully reflects the true, rational value of the security (Fama, 1970) This infers that there is an appropriate price for the security and that the price reflects that true value (Ogden, Jen and O’Conner, 2003) The market price

is set based upon the information available For this reason, information availability and transparency is very important, if all market participants do not have equal access to information price variances may occur Important information includes the anticipated cash flows of the firm, associated risk and discount rate This information allows

informed participants to make decisions about the firm's prospects and enables a fair price to be set through trading by these informed parties Three forms of market

efficiency are discussed as weak form, semi-strong form and strong form (Fama, 1970)

In a weak form, the security's price is reflective of historical prices; value must be derived based upon the historical assessment of the firm by the market This provides little visibility to the firm's future prospects but does provide a trended historical

perspective to evaluate the firm

In a semi-strong form, the security's price is reflective of information that is available to the public, value is derived from information on recent performance and detailed evaluation of the firm is possible given certain financial and performance metrics and ratios This enables evaluation of management decisions and results of operations

including use of capital and changes in cash flow Information may be available through SEC filings, releases and public comments

In a strong form, the security's price is reflective of publicly available information but also includes information that is held privately This provides the greatest visibility

to the firm's prospects and enables effective pricing of the security In this case complete transparency exists and each investor has complete information when making investment decisions External parties have the same access and understanding as individuals within the firm

As can be inferred the challenge in an efficient market is information asymmetry

To be efficient information must be made available and the more information that is available the stronger the efficiency The form of the market is also dependent on the characteristics of the players, perceived security and the efficiency of available

technology Each of these factors impacts the rate of information assimilation and in turn can impact price

1.4 Capital Asset Pricing Model

Differences in the availability of information to the marketplace and the uncertain nature of business results create risk for those seeking to invest in a company’s securities For each organization there are two forms of risk, the risk associated with the market in general and the risk associated with the business decisions and operations of the firm (Burton, 1998) A company’s securities are evaluated relative to the risk associated with

the marketplace in general The Capital Asset Pricing Model (CAPM) suggests that in competitive equilibrium, assets must earn a premium over a corresponding risk-free rate

of return, and the premium demanded increases as risk increases (Ross, 1978) The likelihood that the entire portfolio of companies within a market will fail is modest

compared to the risk that an individual company may fail Given that investors may choose lower risk alternatives, organizations seeking investment must offer higher returns

to attract investment dollars away from safer alternatives The substitutability of

competing investment alternatives results in risk being assigned a price in the

marketplace (Ross, 1978)

The market is continuously assimilating emerging data to inform investment decisions Information is evaluated to determine the appropriate value for a security given its recent performance and future prospects Among the considerations is the perceived risk of the security The model provides a basis for evaluating the trade-off between greater risk and expected returns (Blume and Friend, 1973) CAPM assesses the required return associated with assuming the risk of an investment (Burton, 1998) Sustainability reporting provides additional feedback to the marketplace regarding

individual firm performance and addressed risk by acknowledging the long-term impact

of the company’s operations

The Capital Asset Pricing Model is useful in explaining the returns of established common stocks (Blume and Friend, 1973) The research focused on the common stocks

of publicly traded companies over a five-year period to evaluate performance The model asserts that the risk premium for any asset is linearly related to its covariance with the

broader market (Burton, 1998) This covariance, commonly referred to as the beta

coefficient, provided a measure of the securities volatility The market requires higher rates of return as volatility increases (Kester et al., 1992); this is reflected in the expected growth of the security Given their status as key variables in the Capital Asset Pricing Model, risk and return served as the dependent variables for evaluating the research question

1.5 Purpose of Study

The focus of this study was to evaluate the market’s reaction to additional

disclosure around sustainability The study took the positive approach to test whether companies that engage in reporting beyond legislated financial disclosure, to provide transparency to their operations, realized a premium in the marketplace Sustainability was treated as a manifestation of ethical leadership in which long-term value is balanced with short-term objectives and the interests of multiple stakeholders This was in contrast

to focusing on the identification of unethical companies Unethical companies do not promote their lack of ethics and once that lack of ethics is discovered the firm’s value is destroyed The research sought to establish transparency and enhanced disclosure as best

in class business practices that increase value

If sustainability reporting is embraced as a standard business reporting practice, additional information is made available to the marketplace to potentially facilitate better decision-making The research tested whether companies should get ahead of this trend and voluntarily report as they may receive a premium for their efforts While ethics,

social responsibility and sustainability are voluntary from a reporting perspective,

conducting business in an ethical, socially responsible and sustainable manner is not Cordiero (2003) states, “Being unethical in any arena, but especially in the international arena, is both bad-for-business and bad business” (p 327) As companies expand

globally they are subject to increased scrutiny and potential criticism of their activities

To mitigate this risk, they seek to address the issue of business ethics by complying with their own internal standards as well as national legislation, international labor standards and industry benchmarks (Baker, 2005) Sustainability reporting provides a manner by which organizations can report upon their efforts and success in maintaining compliance and communicate the ethical standards and actions they apply to their operations

1.6 Research Question and Hypotheses

The basic question answered by this study is whether companies that demonstrate ethical leadership through best in class sustainability reporting performed better than their peers in terms of value creation To facilitate exploration of the issue, two datasets are compared relative to the dependent variables of risk and return An understanding of the characteristics of the two datasets facilitated further exploration of the research question Differences in the distribution characteristics of the two datasets required distinct

statistical tests and therefore distinct hypotheses to be applied separately to the variables

of risk and return While the beta (risk) values for the two datasets were normally

distributed, the growth (return) values were not In the case of the growth values, the abnormal distribution may have been the result of under-performing companies dropping out of the securities marketplace over the five-year period being evaluated As such,

Student’s T-test was used to compare the means of the two datasets relative to beta while the Kolmogorov-Smirnov Two Sample test was used to compare the relative distributions

of the growth values for the two datasets In each case the study sought to determine whether significant differences existed between the two datasets This descriptive

information along with the root calculation of the key metrics provided the basis for evaluation of the topic In order to ascertain whether or not a relationship may actually exist between sustainability reporting and financial performance the study tested the following two hypotheses:

Hypothesis 1:

H0: The mean value of risk (beta) of the group of Top Sustainability reporters was greater than or equal to the mean value of risk of the sample of S&P 500

organizations for the period of January 1, 2002 to December 31, 2006

H1: The mean value of risk (beta) of the group of Top Sustainability reporters was less than the mean value of risk of the sample of S&P 500 organizations for the period of January 1, 2002 to December 31, 2006

Hypothesis 2:

H0: The growth of the group of Top Sustainability reporters was less than or equal

to the growth of the sample of S&P 500 organizations based upon the distribution

of return (growth) values for the for the period of January 1, 2002 to December

31, 2006

H1: The growth of the group of Top Sustainability reporters was greater than the growth of the sample of S&P 500 organizations based upon the distribution of return (growth) values for the for the period of January 1, 2002 to December 31,

2006

To facilitate evaluation of the stated hypotheses the following took place:

1) A group of companies recognized as top sustainability reporters was identified along with a listing of companies that comprised the S&P 500 Index

2) These companies were assigned to sectors to ensure a balance between the two datasets in any subsequent selection

3) The performance of the dependent variables of volatility and growth were

evaluated for datasets drawn from the two groups for the period of January 1,

2002 to December 31, 2006

Additional detail regarding the actual procedures used and analytical methods applied is presented in Section 3.5: Selection Procedures, Section 3.6: Data Collection and Section 3.7: Data Analysis in Chapter 3 Research Design and Procedures

1.7 Definition of Terms

AA1000S are assurance standards offered by AccountAbility, a professional institute based in the UK that promotes accountability for sustainable development; the principles include materiality, completeness and responsiveness (AccountAbility, 2003)

Capital Asset Pricing Model (CAPM) is a financial model that asserts that the market value of a security can be impacted by the perceived volatility of that security and

in turn impacts the expected value of future returns (Kester et al., 1992)

Committee on Sponsoring Organizations (COSO) is an independent organization that studies the factors involved in fraudulent reporting suggesting alternatives for

remediation (Gupta and Thomson, 2006)

Compliance is an organization’s efforts to ensure that their activities abide by agreed upon norms including conforming to national laws and international codes as well

as observing the principles for self-regulation (Broadhurst, 2000)

Corporate Governance is the process by which ownership and other stakeholders extend control over managerial action (Ponssard, Plihon and Zarlowski, 2005)

Corporate Social Responsibility views the organization as imbedded in the

community and suggests success is predicated on compliance with the shared values within the society (Brooks, 2005)

Ethical Leadership involves the consideration of the interests of other

stakeholders in determining policy and interests beyond the short-term interest of the individual or individual firm (Resick et al., 2006 pg 357)

Global Reporting Initiative (GRI) is an initiative begun in 1997 with the intention

of improving transparency and supporting sustainable enterprise (GRI, 2006)

Standard and Poor’s 500 Index (S&P 500) is a stock index that is comprised of the most broadly held U.S stocks and widely considered as representative of the

marketplace in general (S&P, 2007)

Sustainability is a concept that incorporates the pursuit of economic benefits with the consideration of environmental and social issues sometimes referred to as the “triple bottom line” of people, planet and profits (Elkington, 1998)

Sustainable Development is development that considers environmental, social and other implications for both immediate and longer-term impacts (Gray and Wiedmann, 1999)

Sustainable Enterprise measures its success not only in terms of profit but also by the organizations ecological integrity and social equity (CSE, 2007)

Sustainability Reporting is additional reporting beyond regulatory requirements that acts as a complement to financial reporting providing not only disclosure but acting

as a communication tool between the organization and its key stakeholders (Wallage, 2000)

United Nations Environment Programme (UNEP) is a program focused on

supporting environmental issues and the consideration of future generations (UNEP, 2007)

Value Creation arises from providing a benefit to consumers, with consumers returning that benefit to the firm in terms of profits and brand loyalty This exchange results in shareholder wealth and is rewarded in the capital marketplace (De Vriend et al., 2000)

1.8 Limitations of the Study

Sustainability reporting is still voluntary and is not a compliance requirement but rather something that the study may suggest to be a best practice Due to the voluntary nature of sustainability reporting it is possible that companies providing enhanced

disclosure were better financial performers already This implies that companies who are profitable have more resources to dedicate to re-investment and social responsibility, however to be profitable in the long-term companies must be sustainable If good

financial performance leads to enhancement in sustainability reporting, then best in class sustainability reporting is one way in which a company can demonstrate sound financial decision-making Invested dollars may be subject to less risk in a sustainable company and may have higher returns This is also why the study did not conclude that companies that fail to report on sustainability issues were bad performers; rather they could

potentially increase their value by doing more to communicate their performance

Sustainability reporting may be a tool to help maximize value by communicating the firm’s ethical pursuit of its objectives to stakeholders; however the research did not imply causality between sustainability reporting and value creation

The study was intended to have the broadest possible impact for global business and as such the group of best in class sustainability reporters did include international organizations The budget and resources available for conducting the study were limited which precluded the research from engaging in a full review of all publicly traded

organizations to select the best sustainability reporters Instead the study accepted the work of an expert resource that employs recognized criteria for sustainability reporting to

identify the top performing companies SustainAbility is an organization dedicated to encouraging high quality transparent reporting Their work is conducted through the application of considerable intellectual and capital resources with financial support from the United Nations and Standard and Poor’s Given the fact that a high quality,

comprehensive and recognized resource already exists for identifying exceptional

sustainability reporting companies this study did not seek to improve upon this group While the study utilized the group derived by that organization, the necessary fieldwork was conducted independently to gather and calculate the key risk and return ratios for the baseline exchange and each of the companies in the selected dataset

1.9 Significance of the Study

Managerial leadership has become more complicated because of, among other things, the almost continuous restructuring activities of many organizations, increasing global competition, demographic changes in the workforce and rapid technological changes (Hooijberg, Hunt and Dodge, 1997) This suggests that organizational structure and competitive response can enhance value

Along with considering the internal issues present within the organization,

professional managers must also understand the external environment in which the

organization operates There are several issues that can result in a changing external environment including political, economic, legal and social factors Macroeconomic fluctuations affect firms’ cash flows as well as market values (Oxelheim and Wihlborg, 2000) As the external environment changes the organization must make adaptive

changes in planning, organizing, and directing its energies toward mission

accomplishment and management therefore must be aware of and respond to changes in the environment (Valle, 1999)

1.10 Summary of the Issue and Problem Statement

Recent failures demonstrate that policies and standards of best practices in

governance alone are not enough to ensure good governance (Busco et al., 2005) Ethical leadership is required to reinforce corporate governance and complement the

organization’s control structure Legal requirements and forced disclosure provide

minimal assurance to the marketplace, and so long as rules provide the basis efforts may

be made to redefine and circumvent their intent Such efforts fail to address the core issue of ethical performance and their ineffectiveness can be summarized by the

following:

Problem Statement - Legislated disclosure provides reactionary guidance that fails

to address performance issues as rules can be circumvented and financial data can be tweaked to reflect its most favorable presentation

To address the broader performance issue, sustainability reporting provides a means by which the organization can communicate its ethical intentions and activities to provide assurance that it is not risking long-term value in the interests of short-term profits Companies that do not have favorable sustainability are still obligated (ethically)

to disclose that status Managers are custodians of shareholder wealth and have a

fiduciary responsibility to manage that wealth proactively If management is withholding key information that would in essence be a misrepresentation of the actual position of the organization and therefore be unethical As an example, if a company were polluting or engaging in unfair labor practices they may not want to talk about it Instead, they may draw attention to the enhanced profitability of the firm and fail to acknowledge the

increased risk represented by these activities To combat ethical lapses, companies should be encouraged to disclose as much information as possible, favorable and

unfavorable, financial and non-financial This study explored whether the idea that disclosing more rather than less information has a positive impact on value

CHAPTER 2 LITERATURE REVIEW

2.1 Overview of the Literature

The role of ethics in business has received significant treatment recently with media sources and organizations themselves increasing focus on the issue The

leadership role of management and establishing the ethical obligations of the firm are areas of the subject that are frequently debated For this reason, some time was spent developing a common understanding of the key concepts before proceeding with the study This provided a basis for exploring the subject and shaped the subsequent

discussion of the findings

The research proceeded from the basic principles of corporate governance to reveal the driving factors and key groups involved in governance Ethical leadership was then explored as a possible complement to governance efforts including the consideration

of competing theories Given the abstract nature of ethics and leadership as business topics, corporate social responsibility and subsequently sustainability and sustainability reporting were discussed as corollaries to ethical leadership The purpose was to both develop a full understanding of these various issues within the context of the study and to establish sustainability reporting as the independent variable Finally, some recent

studies were considered to understand how that work has built the foundation for this current research

Forced governance is among the most basic of alternatives for ensuring

compliance and adequate disclosure The research sought to discover the elements of effective governance and the subsequent value for the market and the firm Within governance attention is given to understanding the various aspects and activities involved including internal operations, external influence and professional standards Despite the significant resources dedicated to financial disclosure and control, ethical lapses continue

to occur This implies that governance alone is not sufficient to ensure ethical behavior

by business leaders To truly ensure ethical performance, ethical leadership is needed to complement governance

The discussion of business ethics is characterized by two competing theories; shareholder theory espousing that the business is only accountable to shareholders and stakeholder theory which incorporates the interests of parties beyond the firm’s

ownership While the two theories are distinct they are not necessarily mutually

exclusive Each requires a level of morality by business leaders and would seek to

balance short-term profitability against long-term value

Corporate social responsibility is a subject that is often associated with

stakeholder theory It demands that business engage in socially responsible behavior and minimize the environmental and human consequences of its activities Corporate social responsibility may further require that the firm provide financial support to social causes Sustainability reporting seeks to provide enhanced transparency to firm’s operations and facilitates communication amongst various stakeholders A review of previous research shows that efforts have been made to explore the issues of corporate responsibility and

ethical performance with respect to financial return, in essence attempting to show that companies can benefit by paying more attention to ethics While these studies suggest that financial returns and internal metrics are often improved they do not show that this necessarily manifests in enhanced market returns or lower risk (Weber et al., 2005) This study sought to further this area of research by evaluating a possible relationship between

an organization’s sustainability reporting efforts and market performance

2.2 Corporate Governance

The corporate accounting scandals that have plagued the global economy bring focus to the idea of corporate governance Today’s organization operates in a

continuously expanding global environment that is both dynamic and increasingly

competitive New challenges are constantly emerging for business leaders and the

increased interest in corporate governance is certainly one The issue is concerned with the operation of an organization within the context of applicable laws and regulations, internal policies, structure and control In practice, well-defined shareholder rights, a strong control environment, full disclosure and transparency of activities and an

empowered board of directors characterize effective corporate governance (IFC, 2006)

Beyond the legal and moral considerations of ethical business practice, companies are concerned with maintaining effective and efficient operations with governance

playing a significant role in driving profitability The result is that demanding best

practice and strict enforcement of governance standards leads to higher valuations in free capital markets (Strenger, 2006) This has global implications as emerging markets seek

to attract capital that will in turn drive economic development Investors are willing to pay a premium to transact with companies that are recognized as possessing good

governance practices (IFC, 2006) As such, industries and markets around the globe must

be concerned with their own governance as they compete for investment capital both domestically and abroad

The reason for the increasing focus on governance is that it not only improves organizational and financial performance but also guards against corruption (Wolfowitz, 2006) Mitigating corruption avoids the market shocks associated with ethical failures

In this way corporate governance protects shareholders and even more broadly the

various stakeholders of the organization Beyond management and ownership,

employees, business partners, customers and the economic market in general benefit from effective corporate governance

Given the far-reaching impact that poor governance can have on the overall economy, government and non-government organizations alike take an active interest in the governance policies of corporate enterprises As the governance landscape is

examined in the United States, the U.S Securities and Exchange Commission (SEC) emerges as an organization dedicated to combating fraudulent activity and ethical lapses through disclosure According to the SEC (2006): “all investors, whether large

institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.” (pg 1)

To facilitate this objective the SEC maintains the Electronic Data Gathering, Analysis, and Retrieval database (EDGAR), an online repository with key filings and financial releases for all companies publicly traded in the United States As an external governance agent the SEC works to protect shareholders and the U.S capital markets by encouraging transparency in reporting, a key aspect of corporate governance To ensure consistent presentation and application, the SEC has designated the Financial Accounting Standards Board as the organization for establishing technical financial accounting and reporting standards (FASB, 2005)

While the SEC and the FASB have been effective as external governance agents, guidelines and requirements cannot address the internal operations of the enterprise Recently, a few very costly scandals emerged as some organizations engaged in financial statement manipulation and outright deception The result was a public outcry for

increased accountability from management New legislation emerged in the form of the Sarbanes-Oxley Act of 2002 Specifically, Section 404 of the act was aimed at ensuring management responsibility for the content of financial reporting through the

implementation of enhanced control processes (Gupta and Thomson, 2006)

The emergence of Sarbanes-Oxley brought renewed focus to the work of the Committee of Sponsoring Organizations of the Treadway Commission (COSO),

officially known as the National Commission on Fraudulent Financial Reporting The commission is an independent private sector initiative focused on studying the factors that influence fraudulent reporting and developing recommendations for remediation (Gupta and Thomson, 2006) Both the SEC and the Sarbanes-Oxley legislation require

the engagement of an external auditor to attest to the fact that the financial statements fairly present the result of operations and that the internal control structure of the

organization is adequate

Beyond the organizations discussed, some private groups have emerged as

independent watchdogs Most have a specific focus such as the environment or human rights; however, each can offer additional insight to an important issue ignored elsewhere

in governance activities (Marsden, 2005) These groups play a significant role in

ensuring that companies are held to a higher standard than merely financial measures when determining success In order to operate efficiently, participants in market

transactions must have complete information including the ethical behavior demonstrated

by a company This can add an important perspective on corporate governance

The external parties discussed are primarily concerned with ensuring adequate information is made available to the marketplace Given sufficient information, the economic and financial markets will ultimately judge the effectiveness of the firm’s governance practices In discussing the beneficial nature of publicity, Louis D Brandeis wrote “To be effective, knowledge of the facts must be actually brought home to the investor, and this can best be done by requiring the facts to be stated in good, large type

in every notice, circular, letter and advertisement inviting the investor to purchase” (1913, p 12) Investors seek opportunities with organizations that demonstrate sound governance policies As such, institutional investors with their high concentration and control of investment dollars, represent a significant voice in determining what

constitutes good governance in practice (Strenger, 2006)

2.2.2 Internal Governance

The external environment produces many challenges including numerous

regulations and requirements that may differ among the various markets in which an organization does business Business leaders are left to make sense of these complex requirements while still expected to ensure the company meets its financial and

operational objectives While the landscape of external governance may be difficult, effective internal governance practices can help ensure the company is able to effectively navigate through this course

Significant responsibility falls to the company’s board of directors who are

expected to set the tone of behavior for the organization while monitoring management plans, decisions and activities; the board is expected to act independently free from the influence of management (Rezaee, 2003) The board of directors is charged with

representing the interests of the shareholders who have entrusted control of their capital investment to management Ultimately, management is responsible for deploying capital

in an efficient and effective way They are accountable for achieving the organization’s operational and financial objectives while demonstrating ethical behavior

Internal control represents a fundamental issue in corporate governance

According to COSO (2006):

Internal control is a process, affected by an entity’s board of directors,

management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: effectiveness

and efficiency of operations, reliability of financial reporting and compliance with applicable laws and regulations (pg 1)

Although the Cohen Commission report in 1978 called for management to own internal controls, until the recent passage of Sarbanes-Oxley the internal audit function was the primary driver of internal control (Gupta and Thomson, 2006) With the passage

of Sarbanes-Oxley and Section 404, responsibility has again been focused on top

management The search for an internal control framework has led publicly traded companies back to the suggestion offered by COSO

The COSO framework is comprised of five interrelated components that impact the manner by which the organization executes on its business plan (COSO, 2006) The components are the control environment, risk assessment, control activities, information and communication and monitoring

The control environment refers to the culture of the organization It begins with the tone established by the board of directors and the example set by senior leadership

In an effective control environment each individual understands that they are expected to act with the highest degree of integrity This is often reflected in the mission statement of the company; however words alone are not enough It must be reflected in the actions of senior management and demonstrated in the daily activities of the company down to its lowest levels The control environment is a pattern of behaviors that become the culture

of the enterprise This provides the basis for building a strong internal control

framework

Risk assessment involves identifying control weaknesses or potential

opportunities for mismanagement This may involve activities that are prone to error or where one individual has significant autonomous authority over a group of assets or transactions Risks are any issues that may jeopardize the ability of the company to achieve its stated objectives This may include an inefficient supply chain or reliance on

a single asset or individual that is crucial to performance Results may be reflected in terms of financial results or lower quality output Identifying the significant risks within the organization before they become issues can result in significant cost savings including safeguarding assets against fraud and other criminal activity

The control activities are those steps that the organization takes to help mitigate the identified risks These activities might involve job rotation, separation of duties, enhanced procedural documentation or other methods of improving control Control activities are implemented at all levels of the organization and are especially important in areas that are considered key activities and have significant impact on the company achieving its organizational objectives and financial reporting

Information and communication play critically important roles in internal control Top management must communicate the importance of the control structure and make sure employees understand the important role they play in achieving results Timely and relevant information must be made available to the individuals are both responsible for key activities and empowered to act upon the information This is not only relevant to internally generated information but also involves external influences such as competitive developments, changes in the supply chain or new regulatory requirements

Finally, a well-developed internal control structure must be monitored to ensure that it is effective and sufficient in dealing with the issues it purports to address This requires continuous evaluation and refinement of the control structure and must become part of the daily operating activities of the organization It involves a formal system of documentation and application to ensure the internal control structure is operating as intended Internal control cannot be a burden shifted to internal audit or some other group relegated to the periphery of the enterprise Rather, ownership must rest with senior management as a key strategic component of the company’s activities and each employee must be empowered to act as an internal control agent to continuously improve the control structure

A number of professional associations and organizations have emerged through the years in part to help formalize the expectations of financial and business managers regarding ethical performance Managers are expected to ensure sound governance and internal control while demonstrating high standards in the completion of their work The Institute of Management Accountants (IMA, 2007) and the Institute of Internal Auditors (IIA, 2007) represent two such organizations that have developed ethical standards for their membership and provide resources to help members understand their role as

business leaders Financial Executive International is an organization comprised of senior financial officers and provides a forum for addressing ongoing and emerging issues related to financial management (FEI, 2007)